UU IFA II Melaku K.

CHAPTER TWO
Property, Plant, and Equipment
2.1. Nature of Plant Assets

Plant assets include long term assets such as property, plant and equipment. The major
distinguishing characteristics of these assets include:
 They are acquired for use in operations and not for resale. Only assets used in
normal business operations should be classified as property, plant, and
equipment. An idle building is more appropriately classified separately as an
investment. Land held by land developers or sub dividers is classified as
inventory.
 They are long-term in nature and usually subject to depreciation. Property, plant,
and equipment yield services over a number of years. The investment in these
assets is assigned to future periods through periodic depreciation charges. The
exception is land. Land is not depreciated unless a material decrease in value
occurs, such as a loss in fertility of agricultural land because of poor crop
rotation, drought, or soil erosion.
 They possess physical substance. Property, plant, and equipment are
characterized by physical existence or substance and thus are differentiated from
intangible assets, such as patents or goodwill. Unlike raw material, however,
property, plant, and equipment do not physically become part of a product held
for resale.

2.2. Accounting for Plant Assets

A plant asset is a bundle of future services. The cost of acquiring such a measure of the
amount invested in future services that will be provided by that asset. At the time of
acquisition, cost is also an objective measure of the exchange value of an asset. The
market price represents the simultaneous resolution of two independent opinions (the
acquirer's and the seller's) as to the current fair value of the asset changing ownership.
There are cases where the acquirer pays too high a price because of errors in judgment or
excessive construction costs, and it is sometimes possible to acquire plant assets at

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bargain prices. These, however, are exceptional cases; accountants seldom have reliable
evidence to support either “unfortunate" or "bargain" acquisitions. Accountants use cost
as the basis of recording and reporting plant assets because it is reliable and because it is
a measure of the investment in future services.

Cost to Acquire Plants, Properties and Equipments

A. Land--the cost of land includes all expenditures incurred to acquire land and to make
it ready for use including the following:
1) Purchase Price--the cost of land includes the purchase price of the land and the
assumption of any liens, liabilities, or encumbrances on the property (such as back
property taxes and an outstanding mortgage)
2) Closing Costs--the cost of land includes closing costs (such as legal fees, title
costs, and recording fees)
3) Preparation Costs-–the cost of land includes costs incurred to get the land in
condition for its intended use (such as grading, filling, draining, clearing, and
demolition of old buildings) less any proceeds obtained in getting the land in
condition for its intended use (such as salvage receipts from the demolition of an
old building and the sale of cleared timber)

Activity
BORENA Brothers Inc., purchased land at a price of Br. 90,000. Clothing costs were Br. 7,500.
An old building was removed at a cost of Br. 48,000. What amount should be recorded as the cost
of the land? (Answer = Br. 145,500).

B. Land Improvements--the cost of land improvements includes all expenditures

incurred to improve the land that are maintained and replaced by the owner including
(1) private driveways, (2) sidewalks, (3) fences, (4) parking lots and (5) lighting.
Note that the major reason to separate land and land improvements will be clear
when we consider depreciation issues in unit five. As you will soon see, land is
considered to have an indefinite life and is not depreciated. Alternatively, you know
that parking lots, irrigation systems, fences, etc., do wear out and therefore be
depreciated.

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C. Buildings - the cost of buildings includes all expenditures incurred that are directly
related to their purchase or construction including: (1) purchase price, professional
fees (i.e., the cost of buildings includes architect’s fees to design the building), (3)
construction Costs (i.e., the cost of buildings includes construction costs from
excavation to completion) and (4) building permits.
D. Equipment--the cost of equipment includes all expenditures incurred in acquiring the
equipment and preparing it for use including (1) purchase price, (2) shipping costs
(i.e., the cost of equipment includes freight and handling charges and insurance on the
equipment while in transit), (3) installation costs (i.e., the cost of equipment includes
the cost of special foundation, assembly and installation) and (4) set up costs (i.e., the
cost of equipment includes the costs of conducting trial runs).

2.3. Special Considerations

A. Cash Discounts
When a plant asset is purchased subject to a cash discount, the discount (whether taken or
not) is considered a reduction in the cost of the asset. The ground reason is that the
additional payment made due to the deferring of the payment is not the cost of the asset
rather it is the penalty of late payment. And the amount of discount lost will be treated as
loss and not part of cost of the asset acquired.
Illustration:
A corporation purchased equipment for Br. 70,000; a cash discount of 2% was available
if payment was made within 10 days; payment was made within the discount period
Equipment = 70,000 – (2% x 70,000) = 68,600
Loss = 0
A corporation purchased equipment for Br. 50,000; a cash discount of 2% was available
if payment was made within 10 days; payment was not made within the discount period:
Equipment = 50,000 – (2% x 50,000) = 49,000
Loss = 1,000 (i.e., Br. 50,000 – Br. 49,000).

B. Deferred Payments

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When a plant asset is acquired by issuing a long-term liability, the cost of the plant asset
is equal to the present value of the future cash payments.
Illustration: BEAECA Trading purchased land by issuing a Br. 500,000, 5-year
noninterest bearing note on January 1 of year 1 when the market rate of interest was
10%; the note is to be repaid in 5 equal installments of Br. 100,000 on December 31 of
year 1, year 2, year 3, year 4 and Year 5.

[ ]
[Note 1
1−(1.1)−5
Cost of Land =Br.100,000
0.1
Cost of Land =Br.100,000×3.79079
Cost of Land =Br.379,079
Note: The formula used to compute the present value of ordinary annuity at interest
rate of 10% for 5 years (recall the time value of money in chapter 5 of financial
accounting I)

C. Issuance of Securities
When a plant asset is acquired by issuing securities, the cost of the plant asset is equal to
either the fair market value of the securities issued or the fair market value of the plant
asset if the fair market value of the securities is not determinable.

Illustration:
a) WISH Corporation purchased machinery by issuing 2,000 shares of common stock
with a par value of Br. 40 and a fair market value of Br. 75; the fair market value of the
machinery was Br. 154,000.
The cost of the machine acquired can be Br. 75 x 2,000 = Br. 150,000
b) If the value of the common stock is unknown, the value of the machine shall be equal
to the fair market value of the machine which is equal to Br. 154,000.

D. Lump-Sum Purchase
It is not unusual for a group of operational assets to be acquired for a single sum. If these
assets are indistinguishable, for example, 5 identical delivery trucks purchased for a lump
sum price of Br. 200,000, valuation is obvious, each of the trucks would be valued at Br.

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40,000 (( Br . 200 , 000÷5 ). however, if the lump-sum purchase involves different assets, it
is necessary to allocate the lump sum acquisition price among the separate items, usually
in proportion to the individual assets’ relative fair market values.

Illustration
LION Company purchased an existing factory for a single sum of Br. 2,100,000. The
price included the title to the land, the factory building and equipment. Independent
appraisal estimated the market values of the assets (if purchased separately) at Br.
800,000 for the land, Br. 1,000,000 for the factory and Br. 700,000 for the building.
The lump sum purchase price of Br. 2,100,000 is allocated to the separate assets as
follows:
Step 1: Determine the percentage of the market value of each asset to the total sum.
Assets Market value Percentage
Land Br. 800,000 32%
Factory 1,000,000 40
Building 700,000 28
2,500,000 100
Step 2: Multiply the percentage of each asset’s market value (computed in step 1, above)
by the lump-sum price to get the cost of the assets and the following journal entry is
recorded:
Land (0.32 × Br. 2,100,000) 672,000
Factory (0.40 × Br. 2,100,000) 840,000
Building (0.28 × Br. 2,100,000) 588,000
Cash 2,100,000

E. Donated Assets
On occasion, companies acquire operational assets through donation. Local government
unit might provide land or pay all or some of the cost of new office building or
manufacturing plant to entice a company to locate in its geographical boundaries; so that
the factory brought jobs to the society and increase revenues to the city.

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Assets donated by unrelated parties should be recorded at their fair value based on either
an available market price or an appraisal value. This is not a departure from historical
cost valuation. The treatment of the transaction is equivalent to the donor contributing
cash to the company and the company using the cash to acquire the asset.
The contribution revenue should be recognized for the excess of the fair market value of
the plant asset over any costs incurred to acquire the plant asset (legal fees, title costs,
etc.).
Illustration: LALU Manufacturing Company a corporation received land with a fair
market value of Br. 790,000 from a city with the stipulation that a factory be built on the
land; the corporation incurred legal fees of Br. 20,000 to obtain title to the land.
Required: i) Determine the cost of the land and contribution revenue.
ii) Pass the journal entry on the book of the LALU Company.
i. Cost of Land = Br. 790,000
Contribution Revenue = Br. 790,000 – Br. 20,000 = Br. 770,000
ii. Journal entry:
Land 790,000
Cash 20,000
Contribution Revenue 770,000
(To Record the acquisition of land)

F. Self Constructed Assets

Occasionally, companies (particularly in the railroad and utility industries) construct their
own assets. Determining the cost of such machinery and other fixed assets can be a
problem. Without a purchase price or contract price, the company must allocate costs and
expenses in order to arrive at the cost of the self-constructed asset. Materials and direct
labor used in construction pose no problem; these costs can be traced directly to work and
material orders related to the fixed assets constructed.
However, the assignment of indirect costs of manufacturing creates special problems.
These indirect costs, called overhead or burden, include power, heat, light, insurance,
property taxes on factory buildings and equipment, factory supervisory labor,
depreciation of fixed assets, and supplies. These costs might be handled in one of two

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ways: (1) Assign No Fixed Overhead to the Cost of the Constructed Asset or (2) Assign a
Portion of All Overhead to the Construction Process.

Interest Costs during Construction

The proper accounting for interest costs has been a long-standing controversy. Three
approaches have been suggested to account for the interest incurred in financing the
construction or acquisition of property, plant, and equipment:
(1) Capitalize no interest charges during construction approach under this approach
interest is considered a cost of financing and not a cost of construction.
(2) Charge construction with all costs of funds employed, whether identifiable or not.
Under this method maintains that one part of the cost of construction is the cost of
financing, whether by debt, cash, or stock financing and
(3) Capitalize only the actual interest costs incurred during construction. This
approach relies on the historical cost concept that only actual transactions are
recorded.
As indicated, in general, capitalizing actual interest (with modification) is the approach
recommended under GAAP/IFRS. This method is in accordance with the concept that the
historical cost of acquiring an asset includes all costs (including interest) incurred to
bring the asset to the condition and location necessary for its intended use.
The rationale for this approach is that during construction the asset is not generating
revenues, and therefore interest costs should be deferred (capitalized). Once construction
is completed, the asset is ready for its intended use and revenues can be earned. At this
point interest should be reported as an expense and matched to these revenues. It follows
that any interest cost incurred in purchasing an asset that is ready for its intended use
should be expensed.
To implement this general approach, three items must be considered:
1. Qualifying assets.
2. Capitalization period.
3. Amount to capitalize.

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Qualifying Assets
Assets that qualify for interest cost capitalization include two types: (1) assets under construction
for an enterprise’s own use (including buildings, plants, and large machinery), and (2) assets
intended for sale or lease that are constructed or otherwise produced as discrete projects (e.g.,
ships or real estate developments).

Capitalization Period
The capitalization period is the period of time during which interest must be capitalized.
It begins when three conditions are present:
a) Expenditures for the asset have been made.
b) Activities that are necessary to get the asset ready for its intended use are in progress.
c) Interest cost is being incurred.
Interest capitalization continues as long as these three conditions are present. The capitalization
period ends when the asset is substantially complete and ready for its intended use.

Amount to Capitalize
The amount of interest to be capitalized is limited to the lower of actual interest cost incurred
during the period or avoidable interest. Avoidable interest is the amount of interest cost during
the period that theoretically could have been avoided if expenditures for the asset had not been
made. For example, if the actual interest cost for the period is Br. 12,000 and the avoidable
interest is Br. 10,000, only Br. 10,000 is capitalized. If the actual interest cost is Br. 10,000 and
the avoidable interest is Br. 12,000, only Br. 10,000 is capitalized.
Note that, in no situation should interest cost include a cost of capital charge for stockholders’
equity. And, interest capitalization is required for a qualifying asset only if its effect, compared
with the effect of expensing interest, is material.
To apply the avoidable interest concept, the potential amount of interest that may be capitalized
during an accounting period is determined by multiplying the interest rate(s) by the weighted-
average accumulated expenditures for qualifying assets during the period.

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Weighted-Average Accumulated Expenditures

In computing the weighted-average accumulated expenditures, the construction expenditures are
weighted by the amount of time (fraction of a year or accounting period) that interest cost could
be incurred on the expenditure.
Interest Rates
The principles to be used in selecting the appropriate interest rates to be applied to the weighted-
average accumulated expenditures are as follows.
i. For the portion of weighted-average accumulated expenditures that is less than or equal
to any amounts borrowed specifically to finance construction of the assets, use the
interest rate incurred on the specific borrowings.
ii. For the portion of weighted-average accumulated expenditures that is greater than any
debt incurred specifically to finance construction of the assets, use a weighted average of
interest rates incurred on all other outstanding debt during the period.

Comprehensive Illustration of Interest Capitalization

To illustrate the issues related to interest capitalization, assume that on November 1, Year 3,
SHOLA Business Group contracted with OLYAD Construction Company to have a building
constructed for Br. 1,400,000 on land costing Br. 100,000 (purchased from the contractor and
included in the first payment). SHOLA Business Group made the following payments to the
construction company during Year 4.
January 1 210,000
March 1 300,000
May 1 540,000
December 31 450,000
Total Br. 1,500,000
Construction was completed and the building was ready for occupancy on December 31, Year 4.
SHOLA Business Group Company had the following debt outstanding at December 31, Year 4.

Specific Construction Debt

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1) 15%, 3-year note to finance purchase of land and construction of the building, dated
December 31, Year 3, with interest payable annually on December 31 Br. 750,000
Other Debt
2) 10%, 5-year note payable, dated December 31, Year 2, with interest payable annually on Br.
December 31 550,000
3) 12%, 10-year bonds issued December 31, Year 1, with interest payable annually on Br.
December 31 600,000

Step (1): Computation of the weighted average accumulated expenditures during Year 4
Expenditure Capitalization Weighted Average
(a) Period Accumulated Expenditure
Date Amount (b)* (c) = (a) × (b)
January 1 Br. 210,000 12÷12
Br. 210,000
March 1 300,000 10÷ 12
250,000
May 1 540,000 8 ÷ 12
360,000
Dec. 31 450,000 0**
0
Br. 1,500,000 Br. 820,000
*Months between date of expenditure and date interest capitalization stops or end of year, whichever
comes first (in this case December 31).
**Note that the expenditure made on December 31, the last day of the year, does not have any interest
cost.

Step (2): Compute the avoidable interest

Weighted Average Interest Rate Avoidable Interest
Accumulated Expenditure (a) (b) (c) = (a)× (b)
Br. 750,000 15%* Br. 112,500
70,000** 11.04%*** 7,728
Br. 820,000 Br. 120,228
*the construction note given
** The amount by which the weighted-average accumulated expenditures exceeds the specific

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construction loan.
Principal Interest
***Weighted-average interest rate computation:
10%, 5 year note Br. 550,000 Br. 55,000
12%, 10 year bonds 600,000 72,000
Br. 1,150,000 Br. 127,000

TotalInterest Br . 127 , 000

= =11. 04 %
TotalPr incipal Br . 1 ,150 ,000
Weighted Average Interest Rate =

Step (3): Compute the actual interest cost, which represents the maximum amount of interest that
may be capitalized during Year 4:
Construction note Br. 750,000 × 0.15 = Br. 112,500
5 year note Br. 550,000 × 0.10 = 55,000
10 year bonds Br. 600,000 × 0.12 = 72,000
Actual Interest Br. 239,500
Step (4): Calculate the amount of interest to be capitalized:
The interest cost to be capitalized is the lesser of avoidable interest (Birr 120,228) or actual
interest (Birr 239,500). In this case, the interest cost to be capitalized is Birr 120,228.
Step (5): Pass the necessary journal entries to be recorded by SHOLA Business Group during
Year 4:
January 1:
Land 100,000
Building (or Construction in Process) 110,000
Cash 210,000
March 1
Building 300,000
Cash 300,000
May 1
Building 540,000
Cash 540,000
December 31

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Building 450,000
Cash 450,000
Building (Capitalized Interest) 120,228
Interest Expense (Br. 239,500 – Br. 120,228) 119,272
Cash (Br. 112,500 + Br. 55,000 + Br. 72,000) 239,500

Capitalized interest cost should be written off as part of depreciation over the useful life of the
assets involved—and not over the term of the debt. The total interest cost incurred during the
period should be disclosed, with the portion charged to expense and the portion capitalized
indicated.
At December 31, Year 4, SHOLA Business Group would disclose the amount of interest
capitalized either as part of the non-operating section of the income statement or in the notes
accompanying the financial statements.

Activity 4.3.2
Assume a 17-month bridge construction project with current-year payments to the contractor of Br.
240,000 on March 1, Br. 480,000 on July 1, and Br. 360,000 on November 1. What is the weighted-
average accumulated expenditures for the year ended December 31.

2.4. Costs Subsequent to Acquisition

After installing plant assets and readying them for use, a company incurs additional costs that
range from ordinary repairs to significant additions. The major problem is allocating these costs
to the proper time periods.
In determining how costs should be allocated subsequent to acquisition, companies follow the
same criteria used to determine the initial cost of property, plant, and equipment. That is, they
recognize costs subsequent to acquisition as an asset when the costs can be measured reliably
and it is probable that the company will obtain future economic benefits. Evidence of future
economic benefit would include increases in (1) useful life, (2) quantity of product produced, and
(3) quality of product produced.
Generally, companies incur four types of major expenditures relative to existing assets.

Major Types of Expenditures

Additions: Increase or extension of existing assets.

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Improvements and Replacements: Substitution of a better or similar asset for an

existing one.
Rearrangement and Reorganization: Movement of assets from one
location to another.
Repairs: Expenditures that maintain assets in condition for operation.
Additions
Additions should present no major accounting problems. By definition, companies capitalize
any addition to plant assets because a new asset is created. For example, the addition of a
wing to a hospital, or of an air conditioning system to an office, increases the service potential of
that facility. Companies should capitalize such expenditures and record them in future periods
when revenues are recognized.
One problem that arises in this area is the accounting for any changes related to the existing
structure as a result of the addition. Is the cost incurred to tear down an old wall, to make room
for the addition, a cost of the addition or an expense or loss of the period? The answer is that it
depends on the original intent. If the company had anticipated building an addition later, then
this cost of removal is a proper cost of the addition. But if the company had not anticipated this
development, it should properly report the removal as a loss in the current period on the basis of
inefficient planning. Conceptually, the company should remove the cost of the old wall and
related depreciation and record a loss. It should then add the cost of the new wall to the cost of
the building. In these situations, it is sometimes impracticable to determine a reasonable carrying
amount for the old wall.
Companies therefore assume the old asset to have a zero carrying amount and simply add the
cost of the replacement to the overall cost.

Improvements and Replacements

Companies substitute one asset for another through improvements and replacements. What is
the difference between an improvement and a replacement? An improvement (betterment) is
the substitution of a better asset for the one currently used (say, a concrete floor for a wooden
floor). A replacement, on the other hand, is the substitution of a similar asset (a wooden floor
for a wooden floor).

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Many times, improvements and replacements result from a general policy to modernize or
rehabilitate an older building or piece of equipment. The problem is differentiating these types of
expenditures from normal repairs. Does the expenditure increase the future service potential of
the asset? Or does it merely maintain the existing level of service? Frequently, the answer is not
clear-cut. Good judgment is required to correctly classify these expenditures.

If the expenditure increases the future service potential of the asset, a company should capitalize
it. The company should simply remove the cost of the old asset and related depreciation and
recognize a loss, if any. It should then add the cost of the new substituted asset.

Rearrangement and Reorganization

A company may incur rearrangement or reorganization costs for some of its assets. The
question is whether the costs incurred in this rearrangement or reorganization are capitalized or
expensed. IFRS indicates that the recognition of costs ceases once the asset is in the location and
condition necessary to begin operations as management intended. As a result, the costs of
reorganizing or rearranging existing property, plant, and equipment are not capitalized but are
expensed as incurred.

Repairs

Ordinary Repairs
A company makes ordinary repairs to maintain plant assets in operating condition. It charges
ordinary repairs to an expense account in the period incurred on the basis that it is the primary
period benefited. Maintenance charges that occur regularly include replacing minor parts,
lubricating and adjusting equipment, repainting, and cleaning. A company treats these as
ordinary operating expenses.
It is often difficult to distinguish a repair from an improvement or replacement. The major
consideration is whether the expenditure benefits more than one year or one operating cycle,
whichever is longer. If a major repair (such as an overhaul) occurs, several periods will benefit.
A company should generally handle this cost as an improvement or replacement.

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Major Repairs
At the time of the major overhaul, the cost and related depreciation to date should be eliminated
and replaced with the new cost incurred for the overhaul.

Type of Normal Accounting Treatment

Expenditure
Additions Capitalize cost of addition to asset account.
Improvements Remove cost of and accumulated depreciation
and on old asset, recognizing any gain or loss.
replacements Capitalize cost of improvement/replacement.
Rearrangement Expense costs of rearrangement and
and reorganization costs as expense.
reorganization
Repairs (a) Ordinary: Expense cost of repairs when
incurred.
(b) Major: Remove cost and accumulated
depreciation of old asset, recognizing any gain
or loss. Capitalize cost of major repair.

Example:
Assume that, ACR Group has been in its plant facility for 15 years. Although the plant is quite
functional, numerous repair costs are incurred to maintain it in sound working order. The
company’s plant asset book value is currently Br.800, 000, as indicated below.
Original cost Br.1, 200,000
Less: Accumulated depreciation 400,000
Book value Br.800,000
During the current year, the following improvements were made to the plant facility.

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a. Because of increased demands for its product, the company increased its plant capacity by
building a new addition at a cost of Br.270, 000.
b. The entire plant was repainted at a cost of Br.23, 000.
c. The original roof was an asbestos cement slate. For safety purposes, it was removed and
replaced with a wood shingle roof at a cost of Br.61, 000. Book value of the old roof was Br.
41,000.
d. The electrical system was updated at a cost of Br.12, 000. The cost of the old electrical system
was not known. It is estimated that the useful life of the building will not change as a result of
this updating.
e. A series of major repairs were made at a cost of Br.75, 000 because parts of the wood structure
were rotting. The cost of the old wood structure was not known. These extensive repairs are
estimated to increase the useful life of the building. The company believes the Br.75, 000 is
representative of the cost of parts for the wood structure at the date of purchase.
Instructions
Indicate how each of these transactions would be recorded in the accounting records.

2.5. Disposition of Property, Plant, and Equipment

Describe the accounting treatment for the disposal of property, plant, and equipment.
A company may retire plant assets voluntarily or dispose of them by sale, exchange, involuntary
conversion, or abandonment. Regardless of the type of disposal, depreciation must be taken up to
the date of disposition. Then, the company should remove all accounts related to the retired asset.
Generally, the book value of the specific plant asset does not equal its disposal value. As a result,
a gain or loss develops. The reason: Depreciation is an estimate of cost allocation and not a
process of valuation. The gain or loss is really a correction of net income for the years during
which the company used the fixed asset. The company should report gains or losses on the
disposal of plant assets in the income statement along with other items from customary business
activities. However, if the company sold, abandoned, spun off, or otherwise disposed of the
“operations of a component of a business,” then it should report the results separately in the
discontinued operations section of the income statement.

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Some of the more common situation involving the retirement, disposal, or exchange of plant
assets includes the following:
1. A fully depreciated plant asset with no residual value is retired without receipt of any
proceeds; no gain or loss is recognized on such retirement.
2. A partially depreciated plant asset is retired without receipt of any proceeds; a loss is
recognized on such retirement.
3. A fully or partially depreciated plant asset is retired or sold with some recovery of net
residual value; a gain or loss is recognized on such retirement or sale.
4. A fully or partially depreciated asset is exchanged for other assets without any cash
being received or paid; the guidelines for the recognition of a gain or loss or such a
nonmonetary exchange transaction are:
a. If a loss is indicated by the terms of the transaction, the loss always is
recognized.
b. If a gain is indicated in an exchange of dissimilar assets that results is for
completion of the earning process (such as the exchange of an inventory item
that cost Br. 800 for a plant asset with a current fair value of Br. 900), the gain is
recognized.
c. If a gain is indicated in an exchange of similar assets that does not complete the
earning process (such as an exchange of a delivery truck for another delivery
truck), the gain is not recognized.
5. A fully or partially depreciated plant asset may be exchanged for a similar asset, with
cash being paid or received by the parties to the transaction. In such exchanges, an
indicated loss is recognized in full, but only a portion of any indicated gain is recognized
by the party receiving cash.
Retirement and Disposals of Plant Assets
Asset disposals may be voluntary, through retirement, sale, or trade-in, or involuntary, from
fire, storm, flood, or other casualty. In general, these terms have the same meaning for
accounting purposes as they do in ordinary discourse. The one exception is retirement, which
for accounting purposes means the removal of an asset from service, whether or not the asset is
removed physically.

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Retirement can be defined as “the removal of a fixed asset from service, following its sale or
the end of its productive life, accompanied by the necessary adjustment of fixed asset and
depreciation-reserve accounts.”
When an asset is retired from service, the cost of the asset and the related amount of
accumulated depreciation must be removed from the books. As part of this entry, the amount
received from the sale or trade-in and any difference between that amount and book value
must be recorded. The difference between the proceeds received on retirement and book
value is a gain (if positive) or a loss (if negative). Depreciation must be recorded for the period
of time between the date of the last depreciation entry and the date of sale.
Illustration:
To illustrate, assume that depreciation on a machine costing Br. 80,000 has been recorded for 9
years at the rate of Br. 8,000 per year. If the machine is sold in the middle of the tenth year for
Br. 4,700, the entry to record depreciation to the date of sale is:
Depreciation Expense 4,000
Accumulated Depreciation-Machinery 4,000
(To record depreciation expense for the six months)
This separate entry ordinarily is not made because most companies enter all depreciation,
including this amount, in one entry at the end of the year. In either case the entry for the sale of
the asset is:
Cash 4,700
Accumulated Depreciation-Machinery 76,000*
Machinery 80,000
Gain on Disposal of Machinery 700**
*[(Br. 8,000 ×9) + Br. 4,000)]
**[Br. 4,700 - (Br. 8,000 – Br. 76,000)]
(To record sale of machine)

Exchange of Plant Assets

Property, plant, and equipment may be acquired by exchange, as well as by purchase.
Accounting for nonmonetary transactions should be based on the fair values of the assets (or

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services) involved. Thus, the cost of a nonmonetary asset acquired in exchange for another
nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss
should be recognized on the exchange. The fair value of the asset received should be used to
measure the cost if it is more clearly evident than the fair value of the asset surrendered.
To make the accounting treatment for exchange of nonmonetary assets more clear we discuss
each concept one by one here under.
In the following paragraphs, we discuss the accounting treatment of each the foregoing situation
under the following three headings:
1. Accounting for dissimilar assets
2. Accounting for similar assets – loss situations and
3. Accounting for similar assets – gain situation
An Exchange of Dissimilar Assets
The cost of a nonmonetary asset acquired in exchange for a dissimilar nonmonetary asset is
usually recorded at the fair value of the asset given up, and a gain or loss is recognized. The fair
value of the asset received should be used only if it is more clearly evident than the fair value of
the asset given up.
Illustration: Golden Transportation Company exchanged a number of used trucks plus cash for
vacant land that might be used for a future plant site. The trucks have a combined book value of
Br. 420,000 (cost Br. 640,000 less Br. 220,000 accumulated depreciation). Golden’s purchasing
agent, who has had previous dealings in the secondhand market, indicates that the trucks have a
fair market value of Br. 490,000. In addition to the trucks, Golden must pay Br. 170,000 cash for
the land.
The cost of the land to Golden is Br. 660,000 (Fair value of trucks exchanged Br. 490,000 +
Cash paid 170,000) and the following journal entry shall be recorded.
Land 660,000
Accumulated Depreciation—Trucks 220,000
Trucks 640,000
Gain on Disposal of Trucks 70,000*
Cash 170,000
*=fair value of trucks (Br. 490,000) minus their book values (Br. 420,000)

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It follows that if the fair value of the trucks was Br. 390,000 instead of Br. 490,000, a loss on the
exchange of Br. 30,000 (Br. 420,000 - Br. 390,000) would be reported. In either case, as a result
of the exchange of dissimilar assets, the earnings process on the used trucks has been completed
and a gain or loss should be recognized.

An Exchange of Similar Assets—Loss Situation

Similar nonmonetary assets are those that are of the same general type, or that perform the same
function, or that are employed in the same line of business. When similar nonmonetary assets are
exchanged and a loss results, the loss should be recognized immediately.
For example, Nani Photo Copy Shop trades its used photo copy machine for a new model. The
machine given up has a book value of Br. 7,500 (original cost Br. 50,000 less Br. 42,500
accumulated depreciation) and a fair value of Br. 5,000. It is traded for a new model that has a
list price of Br. 64,000. In negotiations with the seller, a trade-in allowance of Br. 8,600 is finally
agreed on for the used machine.
The cash payment that must be made for the new asset and the cost of the new machine are
computed as follows.
The cost of new photo copy machine is equal to the list price of the new machine (Br. 64,000)
less the trade-in allowance for used machine (Br. 8,600) plus the book value of used machine
(Br. 5,000) i.e., Br. 60,400.
The journal entry to record this transaction is:
Equipment- New 60,400
Accumulated Depreciation—Equipment old 42,500
Loss on Disposal of Old Equipment 2,500*
Equipment- Old 50,000
Cash 55,400
*=Fair Value of used machine (Br. 5,000) minus Book value of
the used machine (Br. 7,500)= Br. 2,500
Note here that the trade-in allowance or the book value of the old asset are not used as a basis in
computation of the cost of the new asset acquired.
An Exchange of Similar Assets—Gain Situation, No Cash Received

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The accounting treatment for exchanges of similar nonmonetary assets when a gain develops is
more complex. If the exchange does not complete the earnings process, then any gain should be
deferred. Therefore, the asset acquired should be recorded at book value with no gain
recognized. In contrast, had book value exceeded fair value, a loss would be recognized
immediately.
Illustration: Assume that Lily Corporation exchanged old equipment with a cost of Br. 100,000,
accumulated depreciation of Br. 70,000, and a fair market value of Br. 40,000 and paid cash of
Br. 95,000 for new equipment with a fair market value of Br. 135,000.
Required:
1) Determine the amount of gain/loss to be recognized in the exchange.
2) Compute the carrying value of the new equipment.
3) Pass the necessary journal entry to record the exchange.
Solution:
1) Gain = Market value – the book value of the old equipment
Gain = 40,000 – (100,000 – 70,000) = 10,000 - unrecognized
2) Carrying value of the new equipment = the fair market value of the asset - the
unrecognized gain in the exchange = Br. 125,000 (Br. 135,000 - Br. 10,000).
Equipment – New 125,000*
Accumulated Depreciation - Old 70,000
Cash 95,000
Equipment – Old 100,000
(To record the acquisition of equipment with the exchange)
*Note that the carrying value of the new equipment can also be computed as the sum of the Book
value of old equipment (Br. 30,000) and the amount of cash paid in the exchange (Br. 95,000).
Similar Assets—Gain Situation, Some Cash Received
The accounting issue of gain recognition becomes more difficult if monetary consideration such
as cash is received in an exchange of similar nonmonetary assets. When cash is received, part of
the nonmonetary asset is considered sold and part exchanged; therefore, only a portion of the
gain is deferred. The general formula for gain recognition when some cash is received is as
follows.

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¿
Cash Received (Boot)+Fair Value of Other Assets Received ×Total Gain=Recognized Gain
Cash Received (Boot)¿
Illustration: DD Car Renting plc has a rental fleet of automobiles consisting primarily of Ford
Motor Company products. DD’s management is interested in increasing the variety of
automobiles in its rental fleet by adding numerous General Motors models. DD arranges with
KK Car Renting plc to exchange a group of Ford automobiles with a fair value of Br. 160,000
and a book value of Br. 136,000 (cost Br. 200,000 less accumulated depreciation Br. 64,000) for
a number of GM models with a fair value of Br. 170,000. DD pays Br. 10,000 in cash in addition
to the Ford automobiles exchanged.
Though the total gain on the exchange to KK which can never be recognized would be compute
to be Br. 34,000 (i.e., Fair value of GM automobiles exchanged (Br. 170,000) less book value of
GM automobiles exchanged (Br. 136,000).
But because KK received Br. 10,000 in cash, the recognized gain on this transaction is computed
as follows.

¿
Recognized Gain=¿ Br. 10,000 +Br.160,000×Br.34,000=Br.2,000
Br. 10,000¿
Note that the ratio of monetary assets (Br. 10,000) to the total consideration received (Br. 10,000
+ Br. 160,000) is the portion of the total gain (Br. 34,000) to be recognized—that is, Br. 2,000.
Because only a gain of Br. 2,000 is recognized on this transaction, the remaining Br. 32,000 (Br.
34,000 - Br. 2,000) is deferred and reduces the basis (recorded cost) of the new automobiles.
The entry by KK to record this transaction is as follows.
Cash 10,000
Automobiles (Ford) 128,000
Accumulated Depreciation—Automobiles (GM) 64,000
Automobiles (GM) 200,000
Gain on Disposal of GM Automobiles 2,000

2.6. Revaluation of Property, Plant, and Equipment

When companies choose to report at fair value their long-lived tangible assets subsequent to
acquisition, they account for the change in the fair value by adjusting the appropriate asset

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account and recording an unrealized gain on the revalued long-lived tangible asset. This
unrealized gain is often referred to as revaluation surplus and reported as part of other
comprehensive income.
The general rules for revaluation accounting are as follows.
1. When a company revalues its long-lived tangible assets above historical cost, it reports an
unrealized gain that increases other comprehensive income. Thus, the unrealized gain bypasses
net income, increases other comprehensive income, and increases accumulated other
comprehensive income.
2. If a company experiences a loss on impairment (decrease of value below historical cost), the
loss reduces net income and retained earnings. Thus, gains on revaluation increase equity but not
net income, whereas losses decrease net income and retained earnings (and therefore equity).
3. If a revaluation increase reverses a decrease that was previously reported as an impairment
loss, a company credits the revaluation increase to net income using the account Recovery of
Impairment Loss up to the amount of the prior loss. Any additional valuation increase above
historical cost increases other comprehensive income and is credited to Unrealized Gain on
Revaluation.
4. If a revaluation decrease reverses an increase that was reported as an unrealized gain, a
company first reduces other comprehensive income by eliminating the unrealized gain. Any
additional valuation decrease reduces net income and is reported as a loss on impairment.
In the following two sections, we explain revaluation procedures for land and depreciable assets
in a multiple-year setting.
Revaluation of Land
Revaluation—2022: Valuation Increase
To illustrate the accounting for a revaluation, assume that Equatorial Business Group
purchased land on January 1, year 1 that cost Br. 400,000. Unilever decides to report the land at
fair value in subsequent periods. At December 31, year 1, an appraisal of the land indicates that
its fair value is Br. 520,000. The Company makes the following entry to record the increase in
fair value.
December 31, year 1
Land Br. 120,000
Unrealized Gain on Revaluation—Land (Br. 520,000 – Br. 400,000) Br. 120,000

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(To recognize increase in land value)

Date Item Land Fair Retained Accumulated

Value Earnings Other
Comprehensiv
e
Income
(AOCI)
Jan. 1, yr 1 Beg. balance Br. 400,000 0 0
Dec. 31, yr 1 Revaluation Br. 120,000 0 Br. 120,000
Dec.31, yr 1 Ending Balance Br. 520,000 0 Br. 120,000

The land is now reported at its fair value of Br. 520,000. The increase in the fair value of Br.
120,000 is reported on the statement of comprehensive income as other comprehensive income.
In addition, the ending balance in Unrealized Gain on Revaluation—Land is reported as
accumulated other comprehensive income in the statement of financial position in the equity
section.
Revaluation—year 2: Decrease Below Historical Cost
What happens if the land’s fair value at December 31, year 2, is Br. 380,000, a decrease of Br.
140,000 (Br. 520,000 – Br. 380,000)? In this case, the land’s fair value is below its historical
cost. Therefore, The Company debits Unrealized Gain on Revaluation—Land for Br. 120,000 to
eliminate its balance. In addition, Unilever reports a Loss on Impairment of Br. 20,000 (Br.
400,000 – Br. 380,000), reducing net income. The Company makes the following entry to record
the decrease in fair value of the land.
December 31, year 2
Unrealized Gain on Revaluation—Land Br. 120,000
Loss on Impairment Br. 20,000
Land (Br. 520,000 – Br. 380,000) Br.140,000
(To record decrease in value of land below historical cost)

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Date Item Land Fair Retained Accumulated

Value Earnings Other
Comprehensiv
e
Income
(AOCI)
Jan. 1,yr 1 Beg. Balance Br. 400,000 0 0
Dec. 31,yr 1 Revaluation Br. 120,000 0 Br. 120,000
Dec.31,yr 1 Ending Balance Br. 520,000 0 Br. 120,000
Jan. 1,yr 2 Beg. Balance Br.520,000 Br. 120,000
Dec. 31,yr 2 Revaluation (Br.140,000) (Br.20,000) (Br.120,000)
Dec.31,yr 2 Ending Balance Br.380,000 (Br.20,000) 0

The decrease to Unrealized Gain on Revaluation—Land of Br. 120,000 reduces other

comprehensive income, which then reduces the balance in accumulated other comprehensive
income. The Loss on Impairment of Br. 20,000 reduces net income and retained earnings. In this
case, The Company had a revaluation decrease which first reverses any increases that Unilever
reported in prior periods as an unrealized gain. Any additional amount is reported as an
impairment loss. Under no circumstances can the revaluation decrease reduce accumulated
other comprehensive income below zero.
Revaluation—year 3: Recovery of Impairment Loss
At December 31, year 3, the company’s land value increases to Br. 415,000, an increase of Br.
35,000 (Br. 415,000 – Br. 380,000). In this case, the Loss on Impairment of Br. 20,000 is
reversed and the remaining increase of Br. 15,000 is reported in other comprehensive income.
The Company makes the following entry to record this transaction.
December 31, year 3
Land Br. 35,000
Unrealized Gain on Revaluation—Land Br. 15,000
Recovery of Impairment Loss Br. 20,000

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(Revaluation of land, recovery of impairment loss)

Date Item Land Fair Retained Accumulated

Value Earnings Other
Comprehensiv
e
Income
(AOCI)
Jan. 1,yr 1 Beg. balance Br. 400,000 0 0
Dec. 31,yr 1 Revaluation Br. 120,000 0 Br. 120,000
Dec.31,yr 1 Ending Balance Br. 520,000 0 Br. 120,000
Jan. 1,yr 2 Beg. balance Br.520,000
Dec. 31,yr 2 Revaluation (Br.140,000) (Br.20,000) (Br.120,000)
Dec.31,yr 2 Ending Balance Br.380,000 (Br.20,000) 0
Jan. 1,yr 3 Beg. balance Br.380,000 (Br.20,000) 0
Dec. 31,yr 3 Revaluation Br.35,000 Br.20,000 Br.15,000
Dec.31,yr 3 Ending Balance Br.415,000 0 Br.15,000

The recovery of the impairment loss of Br. 20,000 increases income (and retained earnings) only
to the extent that it reverses previously recorded impairment losses.
On January 2, year 4, The Company sells the land for Br. 415,000. The Company makes the
following entry to record this transaction.
January 2, year 4
Cash Br. 415,000
Land Br. 415,000
(To record sale of land)
In this case, Unilever does not record a gain or loss because the carrying amount of the land is
the same as its fair value. At this time, since the land is sold, Unilever will transfer Accumulated
Other Comprehensive Income (AOCI) to Retained Earnings. The entry to record the transfer is
as follows.

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January 2, year 4
Accumulated Other Comprehensive Income Br. 15,000
Retained Earnings Br. 15,000
(To eliminate the remaining balance in AOCI)
The purpose of this transfer is to eliminate the unrealized gain on the land that was sold. It
should be noted that transfers from Accumulated Other Comprehensive Income cannot increase
net income. This last entry illustrates why revaluation accounting is not popular. Even though the
land has appreciated in value by Br. 15,000, The Company is not able to recognize this gain in
net income over the periods that it held the land.

Revaluation of Depreciable Assets

To illustrate the accounting for revaluations using depreciable assets, assume that Glorious
Company purchases equipment for Br, 1,000,000 on January 2, year 1. The equipment has a
useful life of five years, is depreciated using the straight-line method of depreciation, and its
residual value is zero.
Revaluation—year 1: Valuation Increase
Glorious Company chooses to revalue its equipment to fair value over the life of equipment.
Glorious Company records depreciation expense of Br. 200,000 (Br. 1,000,000 ÷ 5) as follows.
December 31, year 1
Depreciation Expense Br. 200,000
Accumulated Depreciation—Equipment Br. 200,000
(To record depreciation expense at December 31, 2022)
After this entry, Glorious Company’s equipment has a carrying amount of Br. 800,000 (Br.
1,000,000 − Br. 200,000). Glorious Company employs an independent appraiser, who
determines that the fair value of equipment at December 31, year 1, is Br. 950,000. To report the
equipment at fair value, Glorious Company does the following.
1. Reduces the Accumulated Depreciation—Equipment account to zero.
2. Reduces the Equipment account by Br. 50,000—it then is reported at its fair value of Br.
950,000.

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3. Records an Unrealized Gain on Revaluation—Equipment for the difference between the fair
value and carrying amount of the equipment, or Br. 150,000 (Br. 950,000 − Br. 800,000). The
entry to record this revaluation at December 31, year 1, is as follows.
December 31, year 1
Accumulated Depreciation—Equipment Br. 200,000
Equipment Br. 50,000
Unrealized Gain on Revaluation—Equipment 150,000
(To adjust the equipment to fair value and record unrealized gain)
Date Item Equipment Accumulat Retained Accumulated
Fair Value ed earnings Other
Depreciatio Comprehensi
n ve
Income
(AOCI)
Jan. 1,yr 1 Beg. balance Br. 1,000,000
Dec. 31,yr 1 Depreciation Br. 200,000 (Br. 200,000)
Dec.31,yr 1 Revaluation (Br. 50,000) (Br. 200,000) Br. 150,000
Dec.31,yr 1 End balance Br. 950,000 0 (Br. 200,000) Br. 150,000

Following these revaluation adjustments, the carrying amount of the asset is now Br. 950,000.
Glorious Company reports depreciation expense of Br. 200,000 in the income statement and
Unrealized Gain on Revaluation—Equipment of Br. 150,000 in other comprehensive income.
This unrealized gain increases accumulated other comprehensive income (reported on the
statement of financial position in the equity section).
Revaluation—year 2: Decrease Below Historical Cost
Assuming no change in the useful life of the equipment, depreciation expense for Glorious
Company in year 2 is Br. 237,500 (Br. 950,000 ÷ 4), and the entry to record depreciation
expense is as follows.
December 31, year 2
Depreciation Expense Br. 237,500
Accumulated Depreciation—Equipment Br. 237,500
(To record depreciation expense at December 31, 2023)

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Under IFRS, Glorious Company may transfer from AOCI the difference between depreciation
based on the revalued carrying amount of the equipment and depreciation based on the asset’s
original cost to retained earnings. Depreciation based on the original cost was Br. 200,000
(Br. 1,000,000 ÷ 5) and on fair value is Br. 237,500, or a difference of Br. 37,500 (Br. 237,500 −
Br. 200,000). The entry to record this transfer is as follows.
December 31, year 2
Accumulated Other Comprehensive Income Br. 37,500
Retained Earnings Br. 37,500
(To record transfer from AOCI to Retained Earnings)
At this point, before revaluation in year 2, Glorious Company has the following amounts related
to its equipment.
Equipment Br. 950,000
Less: Accumulated depreciation—equipment 237,500
Carrying amount Br. 712,500
Accumulated other comprehensive income Br. 112,500 (Br. 150,000 – br. 37,500)
Glorious Company determines through appraisal that the equipment now has a fair value of Br.
570,000.
To report the equipment at fair value, Glorious Company does the following.
1. Reduces the Accumulated Depreciation—Equipment account of Br. 237,500 to zero.
2. Reduces the Equipment account by Br. 380,000 (Br. 950,000 – Br. 570,000)—it then is
reported at its fair value of Br. 570,000.
3. Reduces Unrealized Gain on Revaluation—Equipment by Br. 112,500, to offset the balance in
the unrealized gain account (related to the revaluation in year 2).
4. Records a loss on impairment of Br. 30,000.
The entry to record this transaction is as follows.
Accumulated Depreciation—Equipment Br. 237,500
Loss on Impairment Br. 30,000
Unrealized Gain on Revaluation—Equipment Br. 112,500
Equipment Br. 380,000
(To adjust the equipment to fair value and record impairment loss)

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Date Item Equipment Accumulat Retained Accumulated

Fair Value ed earnings Other
Depreciatio Comprehensi
n ve
Income
(AOCI)
Jan. 1,yr 1 Beg. balance Br. 1,000,000
Dec. 31,yr 1 Depreciation Br. 200,000 (Br.
200,000)
Dec.31,yr 1 Revaluation (Br. 50,000) (Br. 200,000) Br. 150,000
Dec.31,yr 1 End balance Br. 950,000 0 (Br.200,000) Br. 150,000
Jan. 1,yr 2 Beg. balance Br. 950,000 0 (Br.200,000) Br. 150,000
Dec. 31,yr 2 Depreciation Br. 237,500 (Br.237.500)
Dec.31,yr 2 Transfer from Br. 37,500 (Br. 37,500)
AOCI
Dec.31,yr 2 Revaluation (Br.380,000) (Br.237,500) (Br. 30,000) (Br.112,500)
Dec.31,yr 2 End balance Br 570,000 0 (Br.430,000) 0

Following the revaluation entry, the carrying amount of the equipment is now Br. 570,000.
Glorious Company reports depreciation expense of Br. 237,500 and an impairment loss of Br.
30,000 in the income statement (which reduces retained earnings). Glorious Company reports
the reversal of the previously recorded unrealized gain by recording the transfer to retained
earnings of Br. 37,500 and the entry to Unrealized Gain on Revaluation—Equipment of Br.
112,500. These two entries reduce the balance in AOCI to zero.

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Revaluation—year 3: Recovery of Impairment Loss

Assuming no change in the useful life of the equipment, depreciation expense for Glorious
Company in year 3 is Br. 190,000 (Br. 570,000 ÷ 3), and the entry to record depreciation
expense is as follows.
December 31, year 3
Depreciation Expense Br. 190,000
Accumulated Depreciation—Equipment Br. 190,000
(To record depreciation expense)
Glorious Company transfers the difference between depreciation based on the revalued carrying
amount of the equipment and depreciation based on the asset’s original cost from AOCI to
retained earnings. Depreciation based on the original cost was Br. 200,000 (Br. 1,000,000 ÷ 5)
and on fair value is Br. 190,000, or a difference of Br. 10,000 (Br. 200,000 – Br. 190,000). The
entry to record this transfer is as follows.
December 31, year 3
Retained Earnings Br. 10,000
Accumulated Other Comprehensive Income Br. 10,000
(To record transfer from AOCI to Retained Earnings)
At this point, before revaluation in year 3, Glorious Company has the following amounts related
to its equipment.
Equipment Br. 570,000
Less: Accumulated depreciation—equipment Br. 190,000
Carrying amount Br. 380,000
Accumulated other comprehensive income Br. 10,000
Glorious Company determines through appraisal that the equipment now has a fair value of Br.
450,000.
To report the equipment at fair value, Glorious Company does the following.
1. Reduces the Accumulated Depreciation—Equipment account of Br. 190,000 to zero.
2. Reduces the Equipment account by Br. 120,000 (Br. 570,000 – Br. 450,000)—it then is
reported at its fair value of Br. 450,000.
3. Records an Unrealized Gain on Revaluation—Equipment for Br. 40,000.

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4. Records a Recovery of Impairment Loss of Br. 30,000.

The entry to record this transaction is as follows.
December 31, year 3
Accumulated Depreciation—Equipment Br. 190,000
Unrealized Gain on Revaluation—Equipment Br. 40,000
Equipment Br. 120,000
Recovery of Impairment Loss Br. 30,000
(To adjust the equipment to fair value and record impairment loss recovery)

Date Item Equipment Accumulat Retained Accumulated

Fair Value ed earnings Other
Depreciatio Comprehensi
n ve
Income
(AOCI)
Jan. 1,yr 1 Beg. balance Br. 1,000,000
Dec. 31,yr 1 Depreciation Br. 200,000 (Br. 200,000)
Dec.31,yr 1 Revaluation (Br. 50,000) (Br. 200,000) Br. 150,000
Dec.31,yr 1 End balance Br. 950,000 0 (Br.200,000) Br. 150,000
Jan. 1,yr 2 Beg. balance Br. 950,000 0 (Br.200,000) Br. 150,000
Dec. 31,yr 2 Depreciation Br. 237,500 (Br.237.500)
Dec.31,yr 2 Transfer Br. 37,500 (Br. 37,500)
from
AOCI
Dec.31,yr 2 Revaluation (Br.380,000) (Br.237,500) (Br. 30,000) (Br.112,500)
Dec.31,yr 2 End balance Br 570,000 0 (Br.430,000) 0
Jan. 1,yr 3 Beg. balance Br 570,000 0 (Br.430,000) 0
Dec. 31,yr 3 Depreciation Br. 190,000 (Br.190,000)
Dec.31,yr 3 Transfer (Br.10,000) Br. 10,000
from
AOCI
Dec.31,yr 3 Revaluation (Br.120,000) (Br.190,000) Br. 30,000 Br. 40,000
Dec.31,yr 3 End balance Br. 450,000 0 (Br. 600,000) Br. 50,000

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Following the revaluation entry, the carrying amount of the equipment is now Br. 450,000.
Glorious Company reports depreciation expense of Br. 190,000 and an impairment loss
recovery of Br. 30,000 in the income statement. Glorious Company records Br. 40,000 to
Unrealized Gain on Revaluation—Equipment, which increases AOCI to Br. 50,000. On January
2, year 4, Glorious Company sells the equipment for Br. 450,000. Glorious Company makes
the following entry to record this transaction.
January 2, year 4
Cash Br. 450,000
Equipment Br. 450,000
(To record sale of equipment)
Glorious Company does not record a gain or loss because the carrying amount of the equipment
is the same as its fair value. Glorious Company transfers the remaining balance in Accumulated
Other Comprehensive Income to Retained Earnings because the equipment has been sold. The
entry to record this transaction is as follows.
January 2, year 4
Accumulated Other Comprehensive Income Br. 50,000
Retained Earnings Br. 50,000
(To eliminate the remaining balance in AOCI)
The transfer from Accumulated Other Comprehensive Income does not increase net income.
Even though the equipment has appreciated in value by Br. 50,000, the company does not
recognize this gain in net income over the periods that Glorious Company held the equipment.

Exercises
I. Kebeki Company purchased land in 2022 for Br. 300,000. The land’s fair value at the
end of 2022 is Br. 320,000; at the end of 2023, Br. 280,000; and at the end of 2024,
Br. 305,000.
Instructions
Prepare the journal entries to record the land using revaluation accounting for 2022–2024.

II. Endelibu Ltd. owns land that it purchased at a cost of Br. 400 million in 2020. The
company chooses to use revaluation accounting to account for the land. The land’s

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value fluctuates as follows (all amounts in thousands as of December 31): 2020, Br.
450,000,000; 2021, Br. 360,000,000; 2022, Br. 385,000,000; 2023, Br. 410,000,000;
and 2024, Br. 460,000,000.
Instructions
Prepare the journal entries to record the land using revaluation accounting for 2020–2024.

III Star business Group uses revaluation accounting for a class of equipment it uses in its golf
club refurbishing business. The equipment was purchased on January 2, 2022, for Br. 500,000; it

has a 10-year useful life with no residual value. Star has the following information related to the

equipment. (Assume that estimated useful life and residual value do not change during the
periods presented below.)
Date Fair Value
January 2, 2022 Br. 500,000
December 31, 2022 468,000
December 31, 2023 380,000
December 31, 2024 355,000
Instructions
a. Prepare all entries related to the equipment for 2022.
b. Determine the amounts to be reported by Star at December 31, 2023 and 2024, as Equipment,
Other Comprehensive Income, Depreciation Expense, Impairment Loss, and Accumulated Other
Comprehensive Income.
c. Prepare the entry for any revaluation adjustments at December 31, 2023 and 2024.
d. Prepare the entries for the sale of the equipment by Star on January 2, 2025, for Br. 330,000.
2.7. Intangible Assets
Features of Intangible Asset
Intangible assets are rights, privileges and competitive advantages that result from the ownership
of long lived assets that do not possess physical substance. Evidence of intangibles may exist in
the form of contracts, licenses and other documents. Intangibles may arise from;
1. Government grants such as patents, copyrights, franchises, trademarks and trade names.
2. Acquisition of another business in which the purchase price include a payment for
goodwill.

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3. Private monopolistic arrangements arising from contractual agreements, such as

franchises and leases.

In general, accounting for intangible assets parallels the accounting for plant assents. That is,
intangible assets are recorded at cost and this cost is expensed over the useful life of the
intangible asset in a rational and systematic manner. The process of systematically writing off
the cost of intangible assets is called Amortization. APB opinion No.17 requires use of the
straight line method of amortization. At disposal, the book value of the intangible asset is
eliminated and a gain or loss if any is recorded. There is however differences between
accounting for intangible assets and accounting for plant asset. First, the term used to describe
the allocation of the cost of an intangible asset to expense is amortization rather than
depreciation. To record amortization for an intangible asset, an amortization expense is debited
and the specific intangible asset is credited. An alternative is to credit an accumulated
amortization account similar to accumulated depreciation. Most companies however choose
simply to reduce the cost of intangible asset. There is also a difference in determining cost. For
plant assets, cost includes both the purchase price of an asset and the costs incurred by a
company in designing and constructing the plant asset. In contrast, cost for an intangible asset
includes only the purchase price. Costs incurred in developing an intangible asset are expensed
as incurred. A third difference is that, the amortization period of an intangible asset cannot be
longer than 40 years. For example, even if the useful life of an intangible asset is 60 year, it must
be written off over 40 years. Conversely, if the useful life is less than 40 years, the useful life is
used. This rule ensures that all intangibles especially those with indeterminable lives will be
written off in a reasonable period of time. Unlike plant assets intangible assets are typically
amortized on a straight line basis. The widespread use of this method adds comparability in
accounting for intangible assets.
Intangible assets are divided in to two types: Identifiable intangible assets and unidentifiable
intangible assets.

1 Patent
A patent is a right granted to a business enterprise that enables it to exclusively produce and sell
a particular invention for a specified time period. In the United States, this specified time period
is 17 years and the right is granted by the federal government. In Ethiopia, patent rights are

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granted by Ministry of Science and Technology of Ethiopian. There are two main types of
patents: product patents and process patents. Product patents are rights for actual physical
products, while process patents are rights for the process by which they are made, patent rights
may be assigned in part or in their entirety. A patent will have an economic value if at least one
of the following conditions is met:

 The patent has the ability to reduce operating costs.

 It has the ability to result in a higher price for products.
 It is capable of manufacturing and selling a new product.
If an enterprise purchases a patent from another party, the cost of the patent is the sum of
acquisition price and incidental costs. Incidental costs include costs incurred to secure the
patent, legal fees, costs incurred to protect the patent. If the patent is developed internally by the
enterprise itself, the cost of the patent is only the direct legal costs and fees paid to obtain the
right for the patent. Research and development costs that are incurred internally are expensed as
incurred rather than included as costs of the patent.

To understand some of the common accounting issues pertaining to a patent, let’s consider the
following examples.

Example: During year2, Burayu Corporation spent Birr 400,000 in research and development
costs. As a result, a new product was patented at additional legal and other incidental costs of
Birr 40,000. The patent was obtained on July1, year2, and had a legal life of 17 years and a
useful life of 10 years.

The Birr 400,000 expenditures incurred in research and development of the patent should be
expensed as incurred. So, these costs do not become part of the cost of the patent. The actual
cost of the patent for financial accounting purpose is only the Birr 40,000 costs incurred to
secure the patent and incidental costs. Then, on July 1, year 2, the following journal entry would
be made:

Patent ------------------------------------------- 40,000

Cash ------------------------------------- 40,000
Patents are amortized over their useful life not over their legal life. For the year ended July 1,
year 3, the entry to amortize the patent would be:

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Patent Amortization Expense ----------------------------- 4,000

Patent (or Accumulated Amortization – Patent) 4,000
(To record amortization of patents: Birr 40,000 / 10)
Assume further that exactly two years from the date of acquisition, Burayu determined that a
competitor’s product would make the new product obsolete and the patent is expected to be
worthless by July1, year 4. Like any other asset, when the patent is determined to be worthless, it
should be written off. The patent has been amortized for two years and as a result, the
accumulated amortization of the patent on July 1, year 4 would be Birr 8,000 (Birr 4,000 x 2).
Then, the balance of the patent ledger account on the same date would amount.

Cost of the patent ---------------------------------- Birr 40,000

Less: Accumulated amortization ------------------ 8,000
Value of the patent on July1, year 4 ---- ------- Birr 32,000
This amount should be written off on July 1 and a loss is to be recognized for the same amount.

Loss of Impairment -------------------------------- 32,000

Patent -------------------------------------------32,000
(To write off the patent carrying amount)
2 Copyrights

A copyright is a right given by a government to authors, painters, musicians, sculptors and other
artists and creators that enable them to exclusively publish, sell or control literary or artistic
works. Rights given under copyrights may be acquired by business enterprises through:

 Paying periodic royalties

 Acquiring copyright from authors
 Acquiring copyright developed by enterprises themselves
Usually, the legal life of a copyright is longer than its economic life but for financial accounting
purpose, a copyright should be amortized over its useful life. The cost of a copyright includes its
acquisition cost plus costs of defending the copyright. If there are any research and development
costs related to the copyright, such costs should be expensed as incurred. To illustrate accounting
for copyright, look at the example below:

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Example: On January 1, yaer 2, Anbasel Record acquired a copyright for a song from a musician
for Birr 50,000. Anbasel estimated the useful life of the copyright to be twenty years. The
journal entry for Anbasel Records for the acquisition of the copyright on January 1, year 2 would
be:

Copyrights ------------------------------------ 50,000

Cash ------------------------------- 50,000
The amortization of the copyright for the year ended December 31, year 2 would appear as:

Copyrights Amortization Expense ----------------------------2.500

Copyrights (or Accumulated Amortization of copyrights) -- 2,500
(To amortize copyrights: Birr 50,00020)
After the copyright has been amortized just for two years, it is decided that the remaining useful
life of the copyright is 5 years because of unexpected decline in the popularity of the mucian.
Accordingly, the carrying amount of the copyright will be amortized over 5 years from January
1, year 4, on wards. Carrying amount of copyright on January 1, year 4 can be computed as:

Cost of the copyright -------------------------------------- Birr 50,000

Less: Accumulated amortization, (Br. 2,500 x2) --------- 5,000
Carrying amount of the copyright, January 1, 2004 ------- Birr 45,000
Then, the Birr 45,000 carrying amount will be amortized over 5 years. Hence, the journal entry
for amortization of the copyright for the year ended December 31, year 4, would be:

Copyrights Amortization Expense ---------------------------- 9,000

Copyrights (or Accumulated Amortization of copyrights) ---9,000

(To record amortization of copyrights: Birr 45,0005 )

Continuing further on January 1, year 5, Anbasel Records concluded that the copyright is no
more useful to the company. On this date, the carrying amount of the intangible asset should be
written off. The carrying amount of the copyright on the date of impairment is determined as:

Carrying amount of the copyright on January 1, year 4 -------------------- Birr 45,000

Less: Amortization for one year ---------------------------------------------- 9,000
Carrying amount of the copyright on January1, year 5 --------------- Birr 36,000

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Then, the write off journal entry on the books of Anbasel Record on January 1, year 5 would be:
Loss on Impairment ---------------------------------------- 36,000
Copyrights ------------------------------------------ 36,000

3 Licenses and Contracts

Contracts made by a business enterprise and another party for obtaining licenses that enable the
enterprise to acquire some useful rights can be recorded as intangible assets. The licenses are
usually obtained by business enterprises through considerable expenditures. These licenses
allow a firm to participate in some types of business undertakings or to secure rights for making
use of copyright owned by another entity. Licenses are acquired by businesses for various
purposes including:

 Contracts for using telecommunication networks

 Rights acquired for showing movies by a TV station.
 Licenses acquired by a radio station to use airwaves.
 Licenses for using big containers owned by another entity.
The cost of a license or a contract includes the direct costs incurred to acquire the licenses and it
is amortized over the estimated useful life of the contract. If a license or a contract is canceled or
is determined to be useless, the carrying amount is written off as a loss or an expense.

4 .Trademarks and Trade Names

Trademarks and trade names are labels or symbols that are useful to identify or distinguish a
particular product or business enterprise. These distinctive labels help enterprises to develop and
retain customer acceptance to their products. So long as the original user of a trademark or a
trade name continues to use it, the exclusive right remains with this party. A trademark or trade
name used properly, therefore, may be considered as having indefinite life. Like other property
rights, trademarks or trade names may be licensed, assigned or sold.

The cost of a trademark or trade name acquired from others is its purchase price. For trademarks
or trade names (internally) developed by the firm itself, costs include legal fees, registration fees,
design costs, consulting fees, successful legal defense costs, and other direct costs. Research and
development costs, however, are not included in costs of trademarks or trade names.

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Theoretically, trademarks or trade names should not be amortized because of their unlimited life.
But, practically, the cost of these intangibles is frequently amortized over short periods of time.
This is because; the future usefulness of trademarks or trade names is surrounded by many
uncertainties.

Example: General Manufacturing Company spent Birr 50,000 in legal fees, registration fees,
design costs, consulting fees and other costs while developing the trade name of its new product.
The journal entry to record the Birr 50,000 expenditure should have the appearance below:

Trade Names --------------------------------------- 50,000

Cash ---------------------------------------- 50,000
Using a 5-year useful life, the amortization of the trade name for its first year is recorded as:

Trade Name Amortization Expense ---------------------10,000

Trade Names (or Accumulated Amortization - Trade Names) ---10,000
(To amortize the trade name for the first year: Birr 50,000  5)

5 Franchises

A franchise is a right acquired by a business enterprise for securing a privilege to exclusively

engage in a business in a specified geographical area. A franchise right may be acquired from a
governmental entity or from another firm. Two parties are involved in a franchise agreement:
franchiser and franchisee. Franchisor is the party granting the franchise right to the franchise in
return to a consideration. Franchisee is the party obtaining the franchise right from the
franchisor. Costs incurred by the franchisee to acquire a franchise are recorded as an intangible
asset.

The cost of a franchise should be amortized as operating expense over the life of the franchise.
If a franchise is determined to be worthless, it should be written off immediately. Annual
payments made under a franchise contract should be regarded as operating expenses in the period
in which they are incurred.

Example: On January 1, year 7, Tarik Corporation acquired a franchise from Vitex Share
Company for a cash payment of Birr 250,000. In addition, 3% of revenue from the franchise

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must be paid to Vitex as a royalty. The franchise grants Tarik to sell certain products and
services for a period of 8 years.

The cost of the franchise to Tarik Corporation is the acquisition price of Birr 250,000. The 3%
of revenue to be paid periodically should be expensed when incurred. The journal entry on
January 1, year 7, therefore, would be:

Franchise -------------------------------------- 250,000

Cash --------------------------------- 250,000
By December 31, year 7, adjusting entries are required for both the yearly royalty payment and
amortization of the franchise. If the revenue from franchise for the year ended December 31,
year 7 is Birr 1,200,000, the journal entry to record the first royalty payment would be:

Royalty Expense ------------------------------------- 36,000

Cash ----------------------------------------- 36,000
(To record annual payment of royalty: Birr 1,200,000 x 3%)

And the adjusting entry for the amortization of the first year since acquisition should be:

Franchise Amortization Expense -------------------------------- 31,250

Franchise (or Accumulated Amortization of Franchise) 31,250

(To record amortization of franchise: Birr 250,0008)

Unidentifiable Intangible Assets

Not all intangible assets of a business enterprise can be specifically identified. There are a
number of factors that cannot be specifically identified but affect the earning power of an
enterprise collectively. In the forthcoming sections, we discuss an unidentifiable intangible asset
that can only be identified with business entity as a whole. This intangible asset is known in
accounting as Goodwill. In simple language, the term goodwill indicates a sort of positive image
about something or someone. Goodwill is the aggregate of many favorable factors and
circumstances that might contribute to the value and earning ability of a business including:

 Superior management team

 Effective advertising

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 Secret process or formula

 Good relationship between management and employees
 High degree of credit worthiness
 Outstanding human resource development programs
 Good social image
 Favorable relations with customers, suppliers and other enterprises
Goodwill should be recorded in the accounting records only when the amount of the goodwill is
supported by an arm’s length transaction. Because goodwill cannot be sold or exchanged
separately, the recognition of goodwill in accounting is restricted to transactions where entire or
substantial net assets are acquired. Goodwill is recognized for the excess of cost over fair value
of the net assets acquired.

Example: Sarem Corporation is investigating the possibility of acquiring Mocha Share Company
that has an established reputation. The balance sheet of Mocha Share Company is presented as
follows:

Mocha Share Co.

Balance Sheet
December 31, year 8

Liabilities & Owners’ Equity

Assets
Cash Birr 60,000 Accounts payable 200,000
Accounts receivable 190,000 Notes payable 400,000
Inventory 240,000 Total liabilities 600,000
Prepaid insurance 10,000
Buildings and Common stock 200,000
400,000 Retained earnings
equipment (net) 100,000
Total liability &
Total assets Birr 900,000 Stockholders’ Equity Birr900,000

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The fair market values of Mocha’s assets and liabilities on December 31, year 8 are determined
to be as follows:
Cash ----------------------------------------------- Birr 60,000
Accounts receivable --------------------------------- 180,000
Inventory ---------------------------------------------- 300,000
Prepaid insurance ------------------------------------ 10,000
Building and equipment, net ----------------------- 450,000
Accounts payable ------------------------------------ 200,000
Notes payable ----------------------------------------- 400,000
After considerable negotiation Mocha Share Co. accepted Sarem’s offer of Birr 500,000 to
acquire the company. The first procedure here should be to determine the fair value of Mocha’s
net assets on December 31, year 8.

Cash ----------------------------------------------------------- Birr 60,000

Account receivable ------------------------------------------ 180,000
Inventory ------------------------------------------------------ 300,000
Prepaid Insurance -------------------------------------------- 10,000
Building and equipment, net--------------------------------- 450,000
Current fair value of total assets ------------------ Birr 1,000,000
Less: Current fair value of liabilities:
Accounts payable ------------------------------ Birr 200,000
Notes payable ----------------------------------- 400,000
Current fair value of liabilities ------------------- 600,000
Current fair value of net assets ----------------- Birr 400,000
Then, the amount of goodwill is determined as follows:
Purchase price of Mocha Share Co. ------------------ Birr 500,000
Less: Fair value of Mocha’s net assets ----------------------- 400,000
Value assigned to Goodwill ------------------------------------- Birr 100,000

The journal entry to record the acquisition of the net assets of Mocha Share Company on the
books of Sarem Corporation would be as follows;

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Cash --------------------------------------------------- 60,000

Account Receivable ----------------------------------- 180,000
Inventory ---------------------------------------------- 300,000
Prepaid Insurance ------------------------------------ 10,000
Buildings and Equipment (net) ---------------------- 450,000
Goodwill ----------------------------------------------- 100,000
Accounts Payable ---------------------------- 200,000
Notes Payable -------------------------------- 400,000
Cash ------------------------------------------- 500,000
The goodwill we have computed is positive in amount and it is called positive Good Will. If the
fair market value of net assets acquired is greater than the purchase price, negative goodwill
results. Negative goodwill, also called bad will or bargain purchase, results when the rate of
return earned on the net assets of an enterprise is less than the normal rate of return for the
industry in which the enterprise operates. In this circumstance, it would be better to sell the
assets individually than selling the enterprise as a whole.

The excess of fair values over the cost of purchase should be allocated to reduce proportionately
the values assigned to non-current assets of the acquired company (other than long-term
investments in marketable securities). If the allocation reduces the noncurrent assets to zero, the
remainder of the excess over purchase price should be classified as a deferred credit. To
illustrate accounting for negative goodwill assume the previous example except that the purchase
price is Birr 350,000 instead of Birr 500,000. In this case, fair value of net assets exceeds the
cost resulting in negative goodwill.

Purchase price of Mocha Share Company --------------- Birr 350,000

Less: Fair value of Mocha’s net assets ------------------------ -400,000
Negative goodwill ------------------------------------Birr 50,000

The negative goodwill should be charged to buildings and equipment (net), the only non-current
assets of the acquired co., as follows:

Cash -------------------------------------- 60,000

Account Receivable ------------------- 180,000
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Inventory ------------------------------- 300,000

Prepaid Insurance --------------------- 10,000
Buildings and Equipment------------ 400,000
Accounts payable ---------------- 200,000
Notes payable ------------------- 400,000
Cash ----------------------------- 350,000

As noted earlier in this Unit, all intangible assets with indefinite useful lives including goodwill
are not wasting assets. According to APB opinion No. 17, these intangibles are amortized over a
maximum of 40 years. The adjustment for amortization of goodwill would be recorded by:

Goodwill Amortization Expense --------------------------- xx

Goodwill ---------------------------------------------- xx

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